The Art of Venture Capital: Picking and Managing Winning Portfolios

As part of our Founders + Funders SF 2019 summit, held in partnership with Seneca VC, we brought together an exciting group of startup founders and investors for a day of learning, networking and growth.

Our afternoon session on VC funding included Shruti Gandhi, Partner of Array VC, which is a fund focused on enterprise startups, Lan Xuezhao, Founding Partner of Basis Set Ventures, a $100 million fund focused on AI, automation, and machine learning, and Jake Zeller, Partner at Angelist. The conversation was led by Vivian Cheng, Senior Associate at Javelin Venture Partners.

The importance of having operational experience as an investor.

SHRUTI: “You need two things as a venture investor: empathy and the ability to help your founders when they have a question. Empathy comes in many ways, operating is one way of those. Because you’ve been in their shoes before, you can help in that area. The there are additional questions around, “What lawyer do I go to?” or, “I’m in this situation with my co-founder.” Again, if you’ve been in their shoes before as an operator it’s pretty valuable. But if not, it’s the ability to listen, come up with solutions, and connect them to the right people, which is highly valuable again. That’s how I would break the operating role up: the ability to help the founders in their different stages as they grow their company. How you want to develop the skills is up to you, but operating gives you a packaged way of getting that experience beforehand.”

LAN: “Someone did analysis looking at years of experience in VC and the actual performance of said VC partner. There’s essentially no correlation. So the more time you spending being a VC doesn’t actually help you to become better VC. What that points to are the fundamental drivers of what makes it big in venture: a lot of luck, frankly, and a lot of underlying characters such as empathy. You need to be able to connect with the founders and actually get into their round – if it’s actually a really competitive round – and help them in the right way. Being operator is very helpful in developing empathy and thinking from their standpoint. If you’re not an operator, but are a naturally empathetic person, you can also be successful.”

JAKE: “I think you could be a very good investor without having operating experience. But we’re seeing more and more operators get into venture now, and I think it’s harder for the non-operators to compete. If you have a term sheet from one person who’s scaled a company to thousands of employees and exited and is able to see around the corners, and one person who hasn’t, I think you’re going to bias towards the person who has the operating experience.”

Factors and frameworks for evaluating an investment.

LAN: “If you talk to 100 VCs, it’s likely a variation of the following: enormous market, a very strong founder/team, a great product, a defensible technology, defensibility as a business, network effects, and low legal risk. The issue is that you usually can’t get all of them at once. Different VCs will have a different combo of what they’re looking for. Some VC are more market-driven, some are more founder-driven. Even talking about a strong team/strong founder, you often get a lot of different answers. For us, we’re mostly founder-driven. We do a lot of market research, but we don’t work on one particular market full-time. We allow founders to actually know every detail of what’s happening, and the founder side of things is where we spend most of our time. We’ll look at intelligence – smart founders – and at the same time we care about personality. Are you greedy? Are you persistent? Are you good at figuring things out? Do you have experience in the industry? Can you talk to the people?”

JAKE: “It’s team plus market, and both are important. For the team, we look at the strength of the founders and how strong their relationship is together. Co-founder breakups can be dirty. Then, how well-suited they are to attack the market. Ultimately, it’s the market that governs. It’s super, super hard to build a generational company if you’re in a market that’s bad or niche.”

SHRUTI: “We invest in very specific companies – enterprise companies – which means it’s inherently a company that’s selling to another business. Within that, we favor companies that are going after large six-figure contracts. From there, we like large market opportunity. On the team side, we look for three things. The most important thing is the technical team, and having someone who’s done it before. For example, one of our companies we’ve invested in was Simility. They were solving fraud detection, and had done that at Google before for seven years – they came from the industry. Lastly, we make sure the team has the ability to sell. You don’t have to have sales experience, but if not, you should demonstrate the ability to hustle and close the deal. Six-figure contracts are hard to do: you have to be able to go to some executive at an old company and say, “You need this product, and you need it in three months, not four years.””

“The founders of AngelList wrote that the perfect founding team is one person who knows how to code and one person who’s read the book Influence by Robert Cialdini and knows how to implement it.” All panelists agreed this is an excellent book to pick up.

Lessons learned from investment wins and losses.

SHRUTI: “Being in venture longer – for about 8 years now – so far, my track record has not been what VCs would call an outsized return (3 to 5 times return). Array has had few companies acquired by Apple, McGraw-Hill, Samsung, and GoDaddy. We had one acquired by PayPal last year, which was 10x return. But at the end of the day, when VCs talk about exits, they talk about an IPO or a large M&A transaction that’s in the billions. All of us on this panel are still early in that way. I’ve had two fails so far, out of the 55 or so deals I’ve done in last 8 years. It gives you a sense of how long the time horizons are in this industry. You need a lot of patience, and you can go up and down every day with your emotions.”

JAKE: “Angelist did the Series A for Cruise and a few others. Losers, a lot. About 40% to 50% of all companies that raise seed funding through our platform return less than than the capital invested. But ultimately the winners paid back the losers and more. You’re roughly looking at 40% to 50% failure rate in the seed stage VC.”

Advice to founders on reaching or pitching to an investor.

LAN: “A common mistake people make when fundraising is to compile a list of very random VC or search, “What’s the top 10″ and start reaching out to these VCs. One of the most important things to do when you’re fundraising is to find your funder/VC fit. Just like you’re finding your partner fit, you need to find to your funder/VC fit. Not all VCs are going to be a fit for you. You need to find a VC who actually covers your market. You need to find the VC who actually invests in the right size of check that you’re raising. And ideally, one who likes the type of founder you are. Partners have different patterns that they match. Every single partner, every single firm has a different pattern they match. If you’re able to understand what they’re looking for, you have a much higher chance of actually getting through and getting investments. So spend a lot of time trying to understand who you’re selling to, because this is a sales process.”

“You can also look at what companies they’re investing in, and ask for an introduction from the founders they already back.”

JAKE: “Often when I speak with founders, I can feel like I know the market better than they do, which is which is a bad sign. Ideally, a founder is teaching me about a new and exciting market I don’t know about, or coming at it with a new perspective. Having a really crystallized view of what the market is, where it’s going, and then proving that you’re an authority in this topic is helpful. There are counterexamples where that’s not the case, when founders have pivoted into something, but that’s largely my advice.”

“There are three factors that make investors move primarily: social proof, traction, and scarcity. It’s important to know when to leverage them and how. For social proof, if you’re coming out of a well-known tech company and you were a high performer there, you have a lot of people who are going to reference for you and create a ton of social proof. This is helpful if you’re looking to fundraise. For instance, you could get intros to VCs and those VCs will likely want to spend time with you. They’ll give you good ideas on whether your market is good, or whether you can tweak it. Through an iterative process you can end up with a seed round. If you don’t have that social proof, it’s harder, and you’re going to need to demonstrate something and show how skilled you are, largely through generating traction or through other means.”

SHRUTI: “This is tricky. VCs want to be contacted, and they don’t want to be contacted. They want to be contacted by the right company that they would get excited about, and they want it to be from a warm intro. There’s a whole set of scripts they’ve created. When I was a founder, I always thought, “Well how can someone just not quickly look at one quick email and give me a quick response?” But now that I’m on the investment side and drowning in a crazy inbox, I’m getting, I would say, 100+ emails every day, if not more, without the time to act and react to. And the more responses you create, the more you get emails back right away. The responsibility is on the founders to get the attention of the investor, in the right way. I had one email titled,” You found a deal in a hopeless place.” That was the subject line. It’s funny, but I wouldn’t want to fund that founder. Don’t get attention by being smart and witty, but use two things in your cold or warm intros.”

“With cold emails, start with your traction if you have any, your background and experience in the industry if you have any, or your research if you’ve done any. Right? It’s the “take vs give” mindset. Give a gift to someone who’s opening your email. If I’m opening an email from a random person and they’re teaching me about an industry I didn’t know anything about but it could be a fit for my fund – which you should do your homework on – then I give them the time. We’ve done a few deals that have come in cold because the founders got right to the point. They taught me to think about the market, and everything else matched up.”

“With a warm intro, make sure you do the legwork. Create a template: ask the person doing the intro to do the bare minimum, and have them to just forward it and add a line at the top. You’ll get 10 more intros versus them carving out some time for you, rewriting your language, and things like that.”

“There’s no one solution to any of this. But just make sure that you’re educating someone through the process and you look smart in that process as you reach out to someone to ask for money.”

On email subject lines.

SHRUTI: “Found a deal in a hopeless place!”

JAKE: “Again, read the book Influence by Cialdini. There are six principles: commitment and consistency, likability, authority, social power, scarcity, and reciprocity. This could translate to an email subject line like, “Company name, three-sentence description of what you do: X for Y, growing 40% month over month, Z person investing. That’s it. That has all the principles and the subject line, and then you’re done.”

LAN: “They spell my name right! I have a folder of hundreds emails of my name spelled differently.”

SHRUTI: “My last name is making a judgment on you. If you don’t know how to spell Gandhi, I don’t want to fund you.”

Investment styles and choosing your investor.

LAN: “I actually don’t care about social proof. We do a lot of market research. If you’re doing office product improvement, chances are we’ll probably look at most of the companies in the market. So when you come in to pitch, really know what you’re talking about and make sure you’ve looked at all the competitors. We also tend to like founders who’ve had some kind of difficult situation in the past and can follow through. There are a lot of smart people we meet who will give up in six months or a year. Entrepreneurship is a very, very hard thing. So we’ll look for indicators of grit and indicators of strong personality. And the third thing we look at is traction. It doesn’t need to be revenue numbers or growth numbers, because we’re all early-stage investors. Anything that shows that customers love your products, that you have a go-to-market strategy, that you’re getting an initial market fit will be helpful. Where social proof comes in handy is when customers speak highly of you or people who’ve worked with you for a long time. When we do reference checks – which we do a lot, probably do 5 to 10 reference checks for each founder – and people speak highly of you, we take that signal very seriously.”

SHRUTI: “We have a typical founder story for our portfolio companies. Usually they were at a big company, and have 5-7 years of experience. They got really agitated with a particular problem that they were facing, to point where they couldn’t sleep and all they’re doing is talking to their friends about it. One friends says, “I really have this problem. And if you build this, I’ll buy it.” This gives them the conviction to leave their high-paying job to go build this solution, and they also have friends who’ve at least verbally promised their support. When that product is ready is when Array comes in. We usually end up talking to those friends and sussing out how real that commitment is. Then we actually have a customer network of our own that we bring to the table – we call it a second wave of customers. After your first, second, and third friend, how are you going to build the fourth to tenth customer? We bring those into the due diligence process and build our own conviction around the company, and talk to about 5-plus customers before we make an investment in the category. We also normally have a point of view in the category in advance.”

Vetting a co-founder relationship as an investor.

JAKE: “You need to get both co-founders in the room generally, just to see their chemistry together. How are they answering questions? Are they talking over each other? Do they understand what their delineation of responsibilities is? Sometimes if you don’t have them in the same room, they’ll give you contradictory feedback. That’s generally a bad sign. One other thing I try and suss out – it’s a really hard one – but I try and determine if they’re going to sell early. Let’s say they’re creating something related to Google. In the middle of the pitch meeting, I’ll say, “Wow, this is amazing. Google would totally want to buy this for 100 million bucks.” If I see them get excited, I pass, because generally it’s the people who keep going with it and persevere that generate the outsized returns.”

LAN: “I have no problem with single founders. I’m a single founder. So we don’t spend a ton of time assessing co-founder relationships. It’s obvious if the chemistry is off. Spend an hour or two with them and we can sense it.”

The non-financial motivation of a VC.

LAN: “I want to democratize everything. That’s my most secret goal! For instance, when we talk automation, AI is really just giving access to everybody, which by definition is a large market. A lot of companies we invest in make things really cheap and really efficiently. We have a company that making 24/7 security camera, 50 bucks per month. We have an autonomous weeding robot. We have lots of stuff selling cashmere sweater for $50. So yeah. That’s my secret goal.”

SHRUTI: “I’m an immigrant. I came to the US with nothing in ’99. Supported myself through three degrees. I landed in a town called Poughkeepsie, New York, and went to Marist College, which I didn’t even get admitted into because my parents didn’t know I had to get SATs – long story. I got myself into these colleges – if I can do it, you can do it. If I can create networks, you can create networks. If you’re sitting there crying and complaining, I’m going to come teach you not to do that. Get up and do something about it. That’s why I’m here. It motivates me every single day. And if a person of color with nothing is here, you’re already in a better place.”

JAKE: “This is a very capitalists answer, but entrepreneurs are the greatest driver of our economy, innovations, and the privilege a lot of us enjoy today. Free markets have an incredible way of helping society. And I want to further that by investing in the greatest entrepreneurs.”